Why Adjustable Rates May Save Us in Housing Busts

This just in! Cutting a homeowner's mortgage payment in half can reduce the likelihood of delinquency and foreclosure.

That sounds like a no-brainer, but it's a conclusion in a recent report by researchers at the Boston and New York branches of the Federal Reserve.

In fact, the question of what makes homeowners stop paying their mortgage — being unable to afford the payments or being too far underwater — has been a matter of some debate through the foreclosure crisis.

The answer could help us understand what did or didn't work in the current housing mess, and minimize foreclosures when future housing bubbles pop. We may also rethink what kind of lending makes the most sense in any housing market — fixed-rate or adjustable-rate.

Everyone working on the problem agrees that both the size of the monthly payment and negative equity affect a distressed homeowner's decision to stay and pay or to default and run. Early in the crash, conventional wisdom favored reducing payments, but as the crisis deepened the argument swung toward principal reduction, or lowering the amount of debt.

Nearly five years into the crash, which is the better course depends on whom you ask.

One group of economists reads classical economic theory to say that underwater homeowners will make a cold calculation about their unpaid balance and walk away, because doing so immediately saves them the amount they still owe. This logic argues for attacking mass foreclosures by bargaining with banks to reduce the homeowners' debt.

Others, including the authors of the Fed report, say homeowners have other inducements to keep paying even if they don't think they can recover their equity — most significantly, what it would cost them to live elsewhere.

"If the payment is less than what you'd pay in rent, you keep making the payment," said Paul Willen, an economist with the Boston Fed who co-authored the report with Andreas Fuster of the New York Fed.

The two studied default rates on adjustable-rate mortgages (ARMS) written during the boom years, which brought much needed hard data into what had been a largely theoretical debate. The data on defaults had been cloudy, since the information was drawn from programs that divided already delinquent borrowers from those who were still healthy.

Because interest rates fell as the crisis set in, both financially healthy borrowers and unhealthy borrowers had reason to stick with their ARMs. Looking at loans whose rates reset in 2010 and 2011, the researchers got a broader, cleaner set of figures.

The effect of lower payments, they found, turned out to be powerful. Their results showed that cutting a mortgage payment in half would be equivalent to reducing the borrower's loan-to-value ratio from 145 to 95. For the owner of an underwater home worth $200,000, this would be the equivalent of reducing the outstanding mortgage balance from $289,500 to $190,000.

Also recommending lowered payments is the relative lack of friction. Getting a bank to recalibrate an interest payment, in addition, may be an easier task than persuading them to forgive some of the debt entirely.

"You can keep people in the house with even a temporary reduction in the payment," said Willen, as they fight through a job loss or other financial shock.

Homeowners may be more comfortable with this approach, too. The federal government's HARP program has been overwhelmed since it relaunched with fewer limitations last spring, as underwater homeowners rushed to reduce their monthly payments.

Willen notes that there are easier ways than creaky government programs to keep payments fluid through a housing crash. Namely, adjustable-rate mortgages, which Willen says got an undeservedly bad reputation during the crisis.

In fact, he said, "ARMs' role in causing the crisis is quite small." Because ARMs drop, interest rates go down when times are bad and up when life is good, they provide an automatic mechanism for preventing foreclosures, providing stability to the real estate market.

For market watchers, the most interesting part of the report's argument is in framing mortgage payments as call options. When you use a bank loan to take possession of a house, he says, you don't really buy the house; you buy an option to purchase the house from the bank. If you believe that the house will regain its equity, walking away from a mortgage, the authors argue, will always be worth less than exercising this option.

"With the monthly payment, the borrower is paying rent and getting an option to participate in the upside of the house. To induce him or her to make the payment, you can either lower the payment, or increase the potential upside," Willen said.

"In trying to prevent foreclosures, either will work," he said. "But in favor of payment help is that people are not forward looking. If they can make the payment, they will."

For simpler minds, it may be easier to say that houses are sticky investments. "The homeowner values the home more than the market does," Willen said. Houses become repositories for our identity, our memories, and our stuff. And we have hopes that our bet on its value will match our dreams.